Venture capital firms use staged capital where they provide a limited amount of capital to an entrepreneurial company, typically investing enough to help it advance to an important milestone thereby demonstrating that the overall investment risk has been reduced. If the entrepreneurial company performs as expected, as per the business plan, then the next stage (or round) of funding is typically done at a higher evaluation.
However, should the company perform below expectations or have a material adverse event—for example, if the key drug of a pharmaceutical firm performed poorly in an FDA trial—then the valuation of the company would fall, resulting in a down round.
While down rounds are usually the result of performance issues in the portfolio company, they can also be the result of a poor external fundraising environment. An example of this situation was when the Internet bubble collapsed in 2001; this created a major shortage of risk capital, thereby putting companies needing to raise money in a weak bargaining position.